Currency Pairs in Forex Explained
A currency pair quotes one currency against another one, like the EUR/USD pair, where the EUR is the base currency, and the USD is the quote currency.
Each Forex transaction consists of exchanging one currency for another. The International Organization for Standardization (ISO) currency code identifies each currency, such as EUR for the Euro and USD for the US Dollar.
Knowing the currency pair definition includes understanding the currency paring hierarchy. The Euro is always the base currency, together with the British Pound, except for the EUR/GBP pair.
The currency pair hierarchy
- Euro (EUR)
- British Pound (GBP)
- Australian Dollar (AUD)
- New Zealand Dollar (NZD)
- US Dollar (USD)
- Canadian Dollar (CAD)
- Swiss Franc (CHF)
- Japanese Yen (JPY)
What are Currency Pairs in Forex?
Currency pairs in Forex quote one currency against another and form the basis of Forex trading. The same applies to cryptocurrency pairs. In answering the question of what a currency pair is in Forex, this article reveals the countless opportunities the Forex market provides, including active and passive income streams.
Currency pair trading remains a crucial component of global trade, allowing participants to buy, sell, exchange, and speculate on one currency versus another, 24/5, in a decentralized market with a daily turnover approaching $7 trillion, making it the most liquid market globally.
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How Do Currency Pairs in Forex Function?
Forex currency pairs allow traders to buy or go long at the ask price and sell or go short at the bid price of the quote.
An example using the most liquid currency pair, the EUR/USD
- Assume a EUR/USD quote of 1.02143/1.02147
- The Euro (EUR) is the base currency, and the US Dollar (USD) is the quote currency
- 1.02143 is the bid price, the rate at which a trader sells, meaning for each unit of the quote currency (the US Dollar), the trader will receive 1.02143 of the base currency (the Euro)
- 1.02147 is the ask price, the rate at which a trader buys, meaning for each unit of the base currency (the Euro), the trader must pay 1.02147 of the quote currency (the US Dollar)
- If a trader buys EUR/USD, an upward move results in profits, and a downward move results in losses
- If a trader sells EUR/USD, a move higher results in losses, and a move lower results in profits
- The trade size for currency pairs is lots, and 1.0 standard lot equals 100,000 currency units, with the minimum transaction at 0.01 lots or 1,000 currency units
- Some Forex brokers offer mini lots, where 1.0 lot equals 10,000 currency units with a minimum size of 0.01 lots or 100 currency units
- Micro or nano accounts exist at a few brokers serving primarily traders from frontier markets, where portfolio sizes are notably smaller, and 1.0 lot equals 1,000 currency units with a 0.01 lot trade of just ten currency units
- Trading currency pairs also relies on leverage which can range from a competitive 1:500 to an uncompetitive 1:30
How to Read Currency Pair Quotes
Knowing how to read a currency pair quote remains essential to understanding the “how does currency pair work?” question.
How to read currency pair quotes using the GBP/USD pair as an example
- Each currency pair consists of two currencies
- The first currency is the base currency, and the second is the quote currency
- Each currency pair quote has two prices, the bid price, and the ask price
- The bid price is the first price, the one a trader sells the currency pair at
- The ask price is the second price, the one a trader buys the currency pair for
- Assume a GBP/USD quote of 1.19725/1.19733
- The GBP is the base currency, the USD is the quote currency, 1.19725 is the bid price, and 1.19733 is the ask price
- The difference between the bid and ask price is the spread
- Traders in commission-based accounts will get raw spreads as available in the interbank market but pay a commission
- Commission-free accounts will see a higher spread due to the internal mark-up by Forex brokers, which are more expensive than commission-based alternatives, with few exceptions
- Buying the GBP/USD at the ask price of 1.19733 means a trader must pay 1.19733 US Dollars to purchase 1.00000 British Pounds
- Selling the GBP/USD at the bid price of 1.19725 means a trader will receive 1.19725 US Dollar for selling 1.00000 British Pounds
- The ask price is always higher than the bid price in a direct quote
- The fourth decimal of all non-JPY currency quotes, or a fractional cent, is a pip, and 100 pips equal one cent
- For Japanese Yen quotes, the second decimal represents one pip
- The introduction of five decimal quotes resulted in a pipette, the fifth decimal, where ten pipettes equal one pip
- In our example, the bid price of 1.19725 means that 1.00000 British Pounds is worth 1.00000 US Dollars, 19 cents, 72 pips, and five pipettes
- Forex quotes follow a hierarchy, as outlined earlier, resulting in a direct quote
- Forex traders requiring the inverse of the quoted exchange rate, the reciprocal exchange rate, can calculate it by dividing 1.0000 by the bid and ask price
- For example, the GBP/USD direct quote of 1.19725/1.19733 results in an indirect quote of 0.83525/0.83519
Major Forex Pairs Explained
The seven major Forex currency pairs are the US Dollar crosses from the eight primary global currencies. Per 2019 data, the US Dollar accounts for 88%+ of trading volume, followed by 32%+ for the Euro, 16%+ for the Japanese Yen, and 12%+ for the British Pound. The seven major currency pairs account for 75%+ of all Forex trading volume. Therefore, they are the currency pairs with low spreads due to their liquidity.
The seven major currency pairs are:
- EUR/USD
- SD/JPY
- GBP/USD
- USD/CHF
- AUD/USD
- USD/CAD
- NZD/USD
Why Do Traders Trade Major Forex Pairs?
Major Forex pairs offer higher liquidity, which attracts even more liquidity. Therefore, trading costs are lower, and market participants can swiftly buy and sell. Since algorithmic trading approaches 80%+ of daily turnover, and high-frequency trading and scalping remain the most deployed strategies, liquidity and trading costs are defining factors. Trading major Forex pairs also lowers slippage and price gaps but can create crowded trades with increased volatility due to high trading volumes and the number of traders in each direction.
Understanding Currency Pair Correlation
Understanding the currency pair correlation remains crucial to efficient trading. Since currency pairs consist of two currencies and each remains part of numerous pairings, an interdependency exists.
Aspects of correlated currency pairs:
- A high correlation coefficient suggests close price action alignment
- A positive correlation means currency pairs move in the same direction
- A negative correlation refers to an opposite move, often used for hedging
Tips for Efficient Currency Pair Trading
- Establish a deep educational foundation before trading
- Understand trading psychology and its impact
- Evaluate currency pair correlation and currency pair strength
- Develop risk management profiles before entering a Forex trade
- Execute a trusted strategy without mid-trade adjustments
Conclusion
A currency pair consists of a base and quote currency. Buying a currency pair at the ask price means purchasing the base currency and selling the quote currency. Selling at the bid price refers to selling the base currency and receiving the quote currency. Despite two transactions, a currency pair equals one unit, traded 24/5 in the decentralized Forex market, the most liquid financial market globally, as an OTC product.
